Correction… Crash… Or Crisis?

Beginning this month, BE is expanding “Wise Words” to cover more questions you, the readers, have on personal finance. We start our new format by addressing an issue many of you are still puzzling over: October’s market correction. Readers of all levels of investing expertise asked us to explain in just what went on and how they could better position their portfolios to avoid similar shocks in the future. We turned to Randall Elley, president and portfolio ?manager of the Edgar Lomax Co., a Springfield, Virginia, firm that manages $700 million in institutional funds. This past December, the company launched a mutual fund, the Edgar Lomax Value Fund.

Q: We know that a crash, a correction and/or a bear market all mean that stock prices are going down. But what’s the difference among the three?

Eley: A correction is a decline in the market when a stock index, either the Dow Jones Industrial Average or the S&P 500, loses between 7% and 15% of its value, much as we experienced in October 1997. A crash is when that fall happens on one day, two days at the most. A bear market is more drastic, and usually lasts longer. A lot of people say it starts when there’s a correction of at least 20%. Looking back before this past October 29, when stocks slipped 10% or so, the last time we had a full-fledged bear market was in 1987, immediately following the Black Monday crash of October 19, when stocks fell 22%. Then the market sank over 30%, spelling the beginning of an unusually brief but complete bear market.

Q: As a portfolio manager, what’s one way to gauge whether we’re duo for a bear market?

Eley: In very, very basic terms, we look at the valuation of the market in terms of average price-to-earnings multiples (P/E) and dividend rates or yields. Before late October 1997, the S&P 500 was trading at an average 22 or 23P/E, historical highs for the century. The average over time is 14, so stock prices were looking rather high.

Q: Some people say P/Es have to rise because of so much new money coming into the market and falling interest rates.

Eley: That’s what a lot of people said in 1928 and 1929 before the great crash. A lot of people will rationalize an overpriced market for whatever reason. The fact is, throughout history, the market has pretty much traded on a P/E of between 9 and 20, and October’s correction only brought the overall market down to a P/E of 22.5. Yields — the dividend divided by a stock’s price — were about 1.7% for the S&P 500 in October, another sign prices were high. Normally, the S&P 500 has a yield of 3.5%-4%

Q: So what kind of companies do you look for to protect your portfolio from a bear market?

Eley: We look for companies that have traded at low P/Es, generally no more than 20 over the last 10 years, a figure we can find out by looking up the